SEQUENCE-OF-RETURNS RISK

In previous issues, we have argued the need for a more conservative asset allocation for investors who are close to retirement. We continue to hold this view and believe that a prudent allocation to growth assets should not exceed 60% for most retirees.

The reason behind this argument is because the sequence in which retired investors earn their returns matters. If the value of your retirement capital declines just after you start your drawdown programme, the income withdrawn will represent a larger portion of your assets than if you had experienced growth over the same period. This means that in future years you will need to draw a larger portion of the remaining capital to achieve the same level of income.

The importance of the sequence of returns is best illustrated by means of an example (see Figure 3). Consider a portfolio that returns a nominal 11% p.a. and a starting drawdown rate of 7%, which adjusts annually by inflation of 6%. This annualised return of 11% is made up of calendar year returns of 14%, 29%, and -7% respectively, which repeats in the same sequence for the entire investment horizon. If you first experience the two years of positive growth before suffering the 7% loss in the third year, your retirement plan will be sustainable for eight years longer than if you were unlucky enough to experience the 7% loss in your first year of investment (before the two years of gains).

This simplified example illustrates that if a retirement date coincides with an adverse market environment, the impact on accumulated savings can be devastating. Investors are also much more vulnerable to a market loss late in the accumulation cycle (i.e. close to their retirement date), and hence our view that these investors should not be overexposed to risk in the current environment.

INFLATION RISK

Inflation risk refers to the possibility that the future purchasing power of your accumulated capital may be less than you require to maintain your standard of living as a result of rising prices. Any long-term investor, specifically those already in retirement, should therefore primarily be interested in the real, or after-inflation, rate of return. If the rate of return achieved on an investment equals that of the inflation rate, the investor is merely protecting the purchasing power of what has been saved. If the inflation rate exceeds the rate of return achieved, the investor’s purchasing power is reduced.

While the impact of inflation is not that noticeable from year to year, the compounded effect can be devastating. Retirees with a lengthy retirement are especially vulnerable to this risk, as it becomes increasingly more difficult to earn additional income as time passes. At an inflation rate of 6% per year, the purchasing power of one rand today will fall by more than 75% over a period of 25 years.

Expected inflation (see Figure 6) therefore is an important input in the retirement planning process, particularly in a country such as South Africa which continues to struggle with slow growth and stubborn inflation. Inflation expectations have remained above the upper limit of the SARB’s target range almost consistently since 2011, and the latest Bureau for Economic Research (BER) poll shows that South Africans are expecting long-term inflation to remain stuck very close to the 6% target limit.

Sequence-of-returns risk and inflation risk can, to a large extent, be managed by investing in an appropriately constructed portfolio. The right balance between income and growth assets to achieve the dual objectives of reasonable growth after inflation (over the longer term) and capital preservation (over the short term) is essential. On page 17 we discuss Capital Plus and Balanced Defensive, two funds that are managed to meet these objectives. We also include a detailed impact of inflation analysis, comparing Capital Plus to a cash investment, in an appendix on page 19.

LONGEVITY RISK

While it is rather unsettling to think of one’s own mortality, most of us underestimate the investment horizon that needs to be planned for in retirement. Advances in healthcare technology and improvements in nutrition mean that people are living longer, and therefore life expectancy is increasing. For example, if you are a South African female retiring at 65, you can expect to live a further 20 years (see Figure 4). But your effective time horizon may be longer as you may live beyond the average retiree. The prudent approach would therefore be to plan your affairs to have a sustainable income for at least 25 – 30 years. At a 6% inflation rate, this means that you will require nearly six times (allowing for inflation) the level of income at the end of your planning horizon than at the start – just to be able to buy the same amount of goods and services.

​